The Oser View

The Fed RE-Acts Again

This afternoon the Fed lowered the overnight fed funds target by one-quarter of a percent to 4.50%.  As a result, the prime lending rate will drop to 7.50%.  In a statement accompanying the rate decision, the members of the Federal Open Market Committee (FOMC) were careful to be as even-handed as possible.  On the one hand, they pointed out several risks to renewed inflation including solid economic growth in the third quarter and rising prices for oil and other commodities.  On the other hand, the FOMC noted, “The pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.”  (Correction” is FedSpeak for “crisis”.)  The bottom line is that “the upside risks to inflation roughly balance the downside risks to growth.”   

The Fed continues to display the lack of leadership that has characterized it since the summer.  Basically, the FOMC had little choice today but to lower the fed funds target.  Fed funds futures had a nearly 100% probability of a cut, and crossing up the markets could have caused who knows how much damage.  The Fed is supposed to be proactive; instead we have a Fed reacting to today’s economic news.  The first estimate of third quarter Gross Domestic Product was just released this morning!  If the Governors of the Fed have good reason to believe that the economic expansion “will likely slow,” their mandate is to get out in front of the slowdown by lowering interest rates aggressively.  If their analysis convinces them that the expansion remains solid, their mandate is to restrain credit conditions by keeping interest rates stable or even increasing them.

Instead, “the Committee will continue to asses the effects of financial and other developments on economic prospects.”   Just like everyone else.   

What the Stock Market Knows

Ever since it became obvious that there would be hell to pay in the world of subprime mortgages, the big question has been, “Will the consequences be confined or widespread?”  The argument for confinement is that while potential losses on defaulting subprime mortgages will be large—anywhere from $50 billion to more than $200 billion—the number is small in relation to the $10 trillion mortgage market, let alone the broader economy.  The case for wider impact is more nuanced.  It includes the impact of defaults and foreclosures on neighborhood stability, the impact of reduced real estate taxes on municipalities, the loss of spending power from declining home equity, and falling sales at home improvement, home appliance, and similar retailers. 

This summer, the argument took an unexpected turn.  The subprime mess took a vicious swipe at various debt and derivative markets.  Liquidity dried up and remains precarious.  Major banks and brokerage houses both here and abroad are reporting huge drops in third quarter income and in some notable instances, such as Merrill Lynch, large losses.  To help stabilize these markets, the Federal Reserve cuts the fed funds target by 50 basis points and European central banks refrained from expected increases in their base rates.

So why has the stock market been so strong?  Is there some secret or fundamental knowledge underlying the value of corporate America that other markets are missing?  I think the answer is that the stock market has, for quite a long time, been on to a very powerful trend that is underestimated in other quarters.  Before we explore this issue further, however, we need to examine just what the stock market has been up to recently. 

The Dow Jones Industrial Average ended 2006 at 12,463.  It was range-bound in January and February before dropping 3.3% (to 12,216) on February 27.  The sell-off was attributed to the first revelations of widespread failures among subprime lenders, most notably New Century Financial and Fremont General.  But the Dow quickly shrugged off its initial concern, making up its losses by the first week in April.  From there, the average climbed steadily reaching a record 14,000 on July 17.  It collapsed to 12,645 on August 16 as the credit markets seized up.  Since then, it has again fully recovered,getting back to 14,000 on October 1.  Other major stock indices, the S&P 500 and the NASDAQ, show similar patterns.  Since the low on February 27, the three indices have returned 16.6%, 12.6% and 16% respectively. 

The stock market’s longer-term performance is even more impressive.  Over the last five years, ending September 30, the NASDAQ has returned almost 20% and both the Dow and the S&P 500, more than 15%.  The Dow has nearly doubled since its low of 7,267 in October 2002.  Both the Dow and the S&P are at all time highs; only the NASDAQ at 2,780 is still far below its dot-com peak of 5,048.

Ah yes, the dot-com bubble.  The mother of all stock market meltdowns.  Irrational exuberance gone berserk.  How can anyone suggest that stock prices contain some profound insight with the memory of that fiasco still so recent?   Stock markets are forward-looking, and in the late 1990s, the US stock market got ahead of itself.  It overestimated the capital values of emerging Internet and telecommunications companies, but it got the idea very, very right.  Business-to-consumer e-commerce was a paltry $1.8 billion in 1997.  It rose steadily to $70 billion in 2002, right through the stock market collapse and subsequent mild recession.  This year, according to Forrester Research, B2C e-commerce is $259 billion, an 18% increase from 2006.  Business to business e-commerce exceeds $1 trillion. 

In the mid-1970s, Gordon Moore, who later became Chairman of Intel, formulated what became know as Moore’s Law.  The original expression of the law was that the number of transistors an integrated circuit could hold would double every two years, equivalently boosting computer speed and power and reducing their cost.   By the 1990s, the deeper significance of Moore’s Law became evident: All aspects of information processing are expanding exponentially except price for performance, which is declining exponentially.

No end is in sight.  In June, IBM introduced a new computer called Blue Gene/P.  According to the company, Blue Gene/P “operates continuously at speeds exceeding one "petaflop" -- or one-quadrillion operations per second. The system is 100,000 times more powerful than a home PC and can process more operations in one second than the combined power of a stack of laptop computers nearly 1.5 miles high. The Blue Gene/P supercomputer can be configured to reach speeds in excess of three petaflops, a performance level that many thought unattainable only a few short years ago.”

A quadrillion is 10 to the 15th power, or about 1/10th as fast as a human brain, which can perform 10 to the 16th operations a second.  If that seems a big gap, consider the exponential nature of computing progress.  The top of the line IBM computer of the mid-1960s, the 7094, processed 250,000 instructions per second.  By 2000, the fastest supercomputers ran at half the speed of Blue Gene/P.  At the present rate, computer speed will exceed human brain speed in less than 10 years andd keep on going.

Meanwhile, as computing power increases, computing cost decreases.  Entrepreneur and inventor Ray Kurzweil in "The Singularity Is Near" proposes the following paradigm for information technology: At first new technologies do not work well and are extremely expensive.  Next they begin to work a bit better and are still expensive.  Third, they work very well and are cheap.  Finally, they work extremely well and are nearly free.  Obvious and familiar examples are the cell phone and the Internet, but there are many, many more.  The Consumer Price Index confirms that information costs drop virtually continuously.  Over the last three and six months, information technology costs fell 10.7% and 6.6%, while personal computer prices fell 16.8% and 12.4%, a pattern that has been in place for many years

The stock market is responding to the way these exponential trends are being played out in the high levels of corporate productivity and profitability.  These trends are a major and essential factor in the relatively smooth progress of economic expansion since the recession of the early 1990s.  It’s probable that they will prove powerful enough to avert a serious recession this year or next, despite the slump in housing.  I agree with Alan Greenspan in his testimony before the Senate Banking Committee a week after 9/11:

“[T]he American economy has become increasingly resilient to shocks.  Deregulated financial markets, far more flexible labor markets, and, more recently, the major advances in information technology have enhanced our ability to absorb disruptions and recover.”

Less Than Meets the Eye

The Labor Department reported that the US economy added 110,000 new jobs in September and, more importantly, revised the August figures from a loss of 4,000 jobs to an increase of 89,000.  But don’t uncork the champagne yet.  The revisions are almost entirely in government jobs.  As reported last month, government employment declined by a total of 80,000 jobs in July and August.  That number has now been recalculated as an increase of 33,000 jobs, a swing of 113,000.  Governments at all levels added 37,000 positions in September, which seems about the norm.

Private sector employment remains sluggish, adding 73,000 jobs in September and 32,000 in August.  This latter number was revised up only slightly from 24,000 originally reported.  Both manufacturing and construction continue to lose jobs, and those sectors have been joined in loss column by the financial area.  In total, these three sectors have lost 131,000 jobs in the last three months.  A very considerable portion of these lost jobs are directly attributable to the subprime mortgage debacle.  Temporary jobs are also on the decline, with a drop of 20,000 in September.  This is an indication that employers are able to meet their targets with their existing staffs. 

Meanwhile, in a separate report, the unemployment rate hit 4.7%, its highest point since August 2006.  The rate touched a cyclical low of 4.4% in March.